Business transformation is expected to dominate the talk of banker deputies and delegates when the National People's Congress (NPC) and the Chinese People's Political Consultative Conference (CPPCC) convene next month.

A breakthrough in interest rate liberalisation, something shunned by mainland banks for decades, was achieved in June, with the central bank for the first time allowing deposit rates to float up to 10 per cent above benchmark rates.

Such flexibility introduces competition and spells an end to the days when banks could sit on wide interest spreads and make easy profits simply by extending loans.

Once the dust settles following the appointment of top officials to key financial positions after the annual NPC meeting, economists expect interest rate deregulation will accelerate in the next two to three years.

Zhou Xiaochuan is widely expected to stay on as central bank governor after the NPC meeting. Lu Ting, an economist at Bank of America Merrill Lynch, said that retaining the services of the reform-minded official signalled Beijing would continue with unfinished financial reforms.

Zhao Xijun, an economist at Renmin University in Beijing, said: "The financial officials … will together work out a clear road map and timetable for interest rate liberalisation after the NPC and quicken the pace of reform."

Financial officials … will together work out a clear road map and timetable for interest rate liberalisation after the NPC and quicken the pace of reform

It took the US six to seven years to accomplish interest rate deregulation and Japan 11. On the mainland, preparations started in the 1990s but no substantial progress was made until last year, when individuals and companies were attracted to non-bank financial institutions and underground finance markets to seek rates better reflecting market dynamics.

The so-called shadow banking sector has become a major risk factor for the mainland economy. It consisted of an estimated 10.3 trillion yuan (HK$12.7 trillion) of wealth management products at the end of last year, 10.5 trillion yuan in non-bank lending such as trust loans, pawn loans, leasing and private equities, and 3 trillion to 5 trillion yuan of underground lending, according to Mizuho Securities.

The proportion of bank loans in total social financing - a measure of all financing means including corporate bonds and equity issuance - fell from 91 per cent in 2002 to 52 per cent last year, underscoring the declining importance of bank loans.

"The reform is more time-consuming in China because officials and bankers with a planned-economy mindset resisted the change," Zhao said. "However, once the reform kicks off, the trend will not be reversed and the pace will increase in the coming few years."

In a step towards replacing administered interest rates with those decided by the market, the People's Bank of China (PBOC) announced on January 18 the introduction of short-term liquidity operations (SLOs) as part of its open market operations to smooth interbank liquidity and money market interest rates.

The central bank said it would focus the new tool on maturities of less than seven days. Currently, the central bank conducts open market operations each Tuesday and Thursday, and since last year the most-used tools have been seven-day, 14-day and 28- day repos (a form of short-term borrowing for dealers in government securities, in which investors buy government securities and sell them back at a set date) or reverse repos (securities bought with the agreement to sell them at a higher price at a specific future date).

Yao Wei, China economist at Societe Generale said: "This is another major step towards interest rate liberalisation. The rate on the SLOs will be one of the best candidates for the future policy rate."

The central bank was moving towards a price-based, modern monetary policy regime, and the old policy tools, including benchmark lending and deposit rates would be gradually phased out, she said.

Preparations have also been made for a deposit insurance system, another prerequisite for interest rate liberalisation because it protects depositors during a credit crunch.

Wang Tao, an economist at UBS Securities, said she expected Beijing would continue to increase the flexibility of deposit rates in the next two to three years.

Banks' return on equity could drop 40 per cent to 50 per cent if interest rates were liberalised, according to Central China Securities. But if lenders respond well to the challenges, it could be a different story.

Banks have been adjusting their strategies to cope with the changes. Small firms, which big banks used to shun, are gaining popularity as lenders can charge them higher rates for loans, while big companies are increasingly attracted to the bond market by its lower funding costs.

This article appeared in the South China Morning Post print edition as Interest rate liberalisation the focus of bankers at NPC